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June 03, 2006

"Limited founder sales aligns VC, entrepreneur interests"

VC Jeff Bussgang provides more support to the idea that letting founders take "some money off the table" would align their interests better with their VC backers.
Entrepreneurs typically have all their financial eggs in one basket: their start-up. When they have a chance to make good money with 100% certainty, their instinct is to jump at it. If they hold out, “double down” and pursue a bigger outcome, they are simply adding financial risk to their personal portfolio.

Let’s do the math on an example to see how this plays out. Let's say an entrepreneur owns 10% of their VC-backed start-up and someone comes and offers them $100 million. Thus, they stand to make $10 million if they proceed with the sale. Let's say a VC fund owns 20% and thus will take away $20 million, but assume they’ve invested $5 million already in the company, yielding a net capital gain of $15 million. Further, let’s say the VC’s “carried interest” is 20%. Therefore, the general partners of the fund take home $3 million. Let’s say there are 6 partners that split the carry evenly – that’s $500k for each general partner.

So the entrepreneur is thinking “I can take home $10 million now and change my life” and the VC board member is thinking “I can take home $500k and have an 'ok' outcome for me and my fund. But if I push the entrepreneur to ‘double-down’, perhaps we can sell this thing for $200 million in two more years and perhaps we should do a few acquisitions to bulk up to aim for $400 million in four years.” See the problem?

This debate tends to be one of the hardest around the board room, particularly today as the IPO market remains dead but the M&A market has become fairly robust. One discussion I’d like to see more of: VCs allowing entrepreneurs to take money off the table to align interests and address this conundrum. Perhaps I’m too “soft” on entrepreneurs, but I have no problem with an entrepreneur taking a few million off the table so that their mortgage and college tuition is covered, freeing them up to embrace more risk and swing for the fences in a way that is aligned with the VCs. We recently did this in one of our portfolio companies and I've seen a few early exits recently in other start-ups because the VCs didn't do this.

Arun Natarajan is the Founder of Venture Intelligence India, which tracks venture capital activity in India and Indian-founded companies worldwide. View sample issues of Venture Intelligence India newsletters and reports.